Targeting net zero: Practical implications for global investment grade credit portfolios

As we approach the United Nations (UN) Climate Change Conference of the Parties (COP26) in November, we expect increased scrutiny of how investment portfolios are aligning to meet the climate goals of the Paris Agreement and how exposed portfolios are to risks under different climate scenarios. These are topics of growing importance to investors. At Invesco Fixed Income (IFI), we have been examining the practical implications of applying net zero methodologies to global investment grade credit portfolios to ensure that we can support our clients who are looking to align their investing approaches to their own net zero commitments.

Building net zero-oriented investment strategies

The Net Zero Investment Framework (NZIF) created by the Paris Aligned Investment Initiative (PAII) provides a methodology for building investment strategies that are consistent with the goal of achieving global net zero greenhouse gas emissions by 2050. The NZIF also aims to increase investment in the range of “climate solutions” to facilitate achieving net zero. The NZIF recognizes that achieving net zero involves a multi-year transitional effort across the global economy and its approach combines portfolio construction, engagement, and policy advocacy. The framework is more holistic than simple carbon emissions optimizations and looks at where companies sit along a net zero alignment spectrum with a particular emphasis on the material emitting sectors of the economy where transition is vital^.1

Assessing portfolio alignment to net zero 

For fixed income portfolios to become aligned with net zero pathways, we need issuers (from both material and low emitting sectors) to align themselves with the objective of achieving net zero emissions. We see a growing number of global investment grade issuers publicly commit to net zero, and the NZIF sets out specific alignment criteria that issuers must meet to be judged as achieving net zero or making progress towards it. Assessing the actual progress that companies are making against their commitments is critical to this effort.

Data availability, particularly timely emissions information, is an issue that currently hinders the full assessment of transition progress industry-wide, though we do expect improvements in this area as the focus on net zero continues to ramp up among issuers, asset owners, and asset managers. Beyond emissions, data availability is not yet universal across the six core NZIF alignment criteria, which complicates assessing portfolios fully today. The NZIF references three global initiatives – Climate Action 100+ Net Zero Benchmark, the Transition Pathway Initiative, and the Science Based Targets initiative – whose methodologies provide a baseline for evaluating the key global emitters and also can inform the development of in-house, asset manager net zero processes to increase the proportion of portfolios that can be assessed.

It is important to emphasize that issuers with high emissions intensity may still be held in net zero-focused portfolios. However, these material emitting issuers will likely be the focus of close engagement to encourage them to set out and execute on a clear strategy to low carbon, with divestment a final option when progress is not being made against alignment goals. 

Being able to clearly categorize portfolios in the context of the NZIF is key. From this baseline, targets can be set, and decisions are taken accordingly. IFI is starting to map portfolios and benchmarks along the net zero alignment spectrum (see Figure 1) with the intention of then deciding what an appropriate evolution should look like over time.

Investment in climate solutions 

While the NZIF encourages increased investment in “climate solutions” (e.g., emerging technologies that are helping the achievement of net zero goals), investment grade portfolios generally have relatively modest exposure currently. This is not surprising, in our view, given the public fixed income market’s inherent bias toward more established issuers (“old economy”) versus cutting-edge green startups (“new economy”), due in no small part to the minimum business size needed to support publicly traded debt. However, we are optimistic that this area can grow significantly, given the rapid uptake of electric vehicles, energy efficiency solutions, and renewable energy, where investment grade issuers have meaningful exposure. We also see some logic to incorporating green bonds into the “climate solutions” segment, especially bonds strongly aligned with UN Sustainable Development Goals. The EU taxonomy should also help to create much needed standardized reporting.

Analyzing the impact of climate change on portfolios

Climate scenario analysis is complementary to the NZIF and allows investors to see how their portfolios would perform in different climate outcomes, including net zero, by 2050, but also in adverse scenarios to demonstrate the risks of inaction. Our analysis incorporates the use of Planetrics climate risk modeling, which estimates a value impairment at the portfolio level of a relatively modest -1%, even in adverse scenarios (a hot-house world or delayed transition)^.2 There are several reasons for this, but the significant equity cushion, favorable geographical exposures (developing markets more exposed to physical climate risk than developed) and relatively low duration of the asset class are all important factors. This conclusion should not detract from the valuable insights and mitigation that can be achieved from closer analysis of issuer, sectoral, or geographical exposures, but we think it helps put the risk in this relatively nascent area into perspective.

Growing investor focus on net zero

With COP26 approaching, we are expecting investor interest in net zero alignment to increase significantly in response to its goal of mobilizing finance to secure global net zero by mid-century. The effort to meet net zero will likely require financing alignment to occur across the whole asset class spectrum, which is why the net zero investment framework also covers equities, sovereign debt, and real estate in addition to corporate bonds. Corporate bond portfolios will have an important role to play in this transition. Even though the impacts on bond values from different climate scenarios may be less marked than on other asset classes such as equities, we still expect investors to be increasingly keen to understand how their portfolios align with the pathway to net zero as well as how they fare in different climate scenarios.

Given the numerous factors incorporated into a decision to invest in a fixed income portfolio (fundamental credit quality, environmental, social, and governance (ESG) credentials, net zero alignment, climate change exposure), we believe investors cannot adopt a “one size fits all approach.” IFI is closely monitoring ESG risks across its portfolios and especially in the rapidly evolving net zero alignment space. We believe having a wellresourced and experienced credit team is important for assessing the issues raised here and to inform our investment decisions. IFI seeks to ensure that credit spreads adequately reflect downside risks, including ESG factors, or, where this is not the case, that “at-risk” names are avoided. 

^{^1 Material emitting sectors are defined as those  which in aggregate contribute to 80% global carbon emissions. 
^2 Source: Planetrics, June 2021. Planetrics is a part of the Vivid Economics group of companies.}